THE THEORY OF CONSUMER BEHAVIOUR

UTILITY: Is the satisfaction an individual gains from consuming certain amount of a

commodity. For instance, for a student on UCC campus to eat kenkey, there’s a level of
satisfaction (utility) that individual gains.

TOTAL UTILITY: The total amount of satisfaction an individual gains from consuming certain
amount of a commodity. TU=ƩMU or AU*Q

MARGINAL UTILITY: The additional satisfaction an individual gains from consuming an

additional unit of a good. MU=dTU/dQ

AVERAGE UTILITY: The satisfaction per unit of a commodity consumed. AU=TU/Q

EQUILIBRIUM CONDITION FOR A SINGLE COMMODITY;

For a consumer to achieve the highest satisfaction from a good, the marginal utility of that good
should be equal to the price of that good. MUx =Px

EQUILIBRIUM CONDITION FOR TWO COMMODITIES

In two commodities scenario, in order for a consumer to achieve the highest level of satisfaction,

MUx /Px =MUy /Py.

SCHOOLS OF THOUGHTS IN CONSUMER BEHAVIOUR

ORDINALIST: They believed that the utility cannot be quantified or measured. That is, an
individual cannot measure the amount of satisfaction gained from consuming a commodity.
However, to ordinalist, an individual can simply compare the different levels of satisfaction by
judging whether the satisfaction derived from a good is higher or lower. They employed the use
of an indifference curve.

CARDINALIST: The cardinal school of thought believed that utility can be measured or
quantified. Their argument was based on certain axioms which are stated below;

Rationality of the consumer

Disposable income of the consumer is given
Tastes and preferences are given
There is perfect competition in the goods market, that is prices of goods are given
Marginal utility is positive
Utility is measurable/quantifiable

EQUI-MARGINAL PRINCIPLE: MUx /Px =MUy /Py

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BUDGET SET: A set of bundles (set of goods) bounded by the budget line that the consumer
can afford. M ≤ PxX +PyY

BUDGET LINE: A set of bundles (set of goods) that yield the same level of expenditure.

A budget line is of the expression; M= PxX+PyY

SLOPE OF BL: -Px/Py

SHIFTING OF THE BUDGET LINE

A budget line shifts when there is a change in income. This shift can be either to the left or right
depending on the income change (whether income decreased or increased)

INCREASE IN INCOME: An increase in income shifts the budget line to the right.
This means that the consumer can buy more of both goods given the income.
DECREASE IN INCOME: A decrease in income shifts the budget line to the left. This
means that the consumer can buy less of both goods given the income.

ROTATION OF THE BUDGET LINE

A budget line may rotate when there is a price change. The rotation can be to the inward or
outward of the budget line given the price change.

INCREASE IN PRICE: An increase in the price of let say good X will result in an
inward rotation of the budget line. This means that the consumer will buy a smaller
quantity of good X due to an increase in the Px.
DECREASE IN PRICE: A decrease in the price of let say good X will result in an
outward rotation of the budget line. This means that the consumer will buy a larger
quantity of good X due to a decrease in the Px.

INDIFFERENCE CURVE

An indifference curve is a curve or line that shows all combinations of goods that provide the
consumer with the same level of satisfaction (utility). Thus, the consumer finds all combinations
on the curve equally preferred (the consumer is indifferent).

SLOPE OF IC: -MUx/MUy

BASIC ASSUMPTIONS OF AN INDIFFERENCE CURVE

Negatively sloped
Convex to the origin
The further away the IC from the origin, the higher the level of satisfaction
Indifference curve does not intersect

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 SUBSTITUTION AND INCOME EFFECTS

Total effect: the resulting total change in the quantity demanded of x 1 when the price of x1
changes (comparing two equilibrium positions—one before and one after the price change). The
total effect can be decomposed into two separate effects: The substitution effect and the income
effect.

Substitution effect: is an incentive to increase consumption of a good whose price falls, at the
expense of the other, now relatively more expensive good.

Income effect: a change in consumer’s real purchasing power brought about by a change in the
price of a good. Ultimately, the consumer’s change in the quantity of the good depends on if the
good is normal or inferior.

(A) The substitution effect will always result in the person consuming more of the good for
which the price has decreased. It will always result in the person consuming less of the good for
which the price has increased.

It does not matter if it is a normal or inferior good.

If Px , then the substitution effect will be positive (I buy more x)
If Px , then the substitution effect will be negative (I buy less x)

(2) The income effect will differ depending on if the good is normal or inferior.

 If the price of a good decreases, it is as if you have more income (a higher level of
purchasing power).
 If the price of a good increases, it is as if you have less income (a lower level of
purchasing power)

 Normal good: higher income (Px) results in higher consumption of x. Income effect is
positive.
 Normal good: lower income (Px) results in lower consumption of x. Income effect is
negative.

 Inferior good, higher income (Px) results in lower consumption of x. Income effect is
negative.
 Inferior good, lower income (Px) results in higher consumption of x. Income effect is
positive.

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PROCEDURES IN CALCULATING THE SUBSTITUTION AND INCOME EFFECTS

Use the old utility value

Use the new price change (use the new price given in the question)
Substitute your demand functions for X and Y into the utility function to find the new
income
Use the new income to calculate for the new optimal choice of the consumer in order to
solve for INCOME AND SUBSTITUTION EFFECT

COMPENSATING AND EQUIVALENT VARIATION

COMPENSATING VARIATION (PRICE FALL): The maximum amount of money

that has to be taken away from the consumer to make them as well off as before the price
decreases. CV=Y₀ -Y₁
EQUIVALENT VARIATION (PRICE FALL): The minimum amount of money that
has to be given to the consumer to make them as well off as before the price decreases.
CV=Y₂ - Y₀

PROCEDURES IN CALCULATING COMPENSATING AND EQUIVALENT

VARIATION

Use the new utility value

Use the old price change (use the old price given in the question)
Substitute your demand functions for X and Y into the utility function to find the new
income
Use the new income to calculate for the new optimal choice of the consumer in order to
solve for COMPENSATING AND EQUIVALENT VARIATION.

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